Stock market "noise" and the role of large fund management firms
Institutional Communication Service
In an efficient capital market, the fundamental value of a firm is normally reflected in the price of its shares. However, stock prices are subject to demand pressure, which can sometimes cause large deviations from correct valuations. This dynamic is worsened when investors are large management firms, who buy or sell shares in big quantities. The impact of these transactions can lead to deviations from the correct valuation of the firm. The Financial Times has recently reported the results of an empirical study on this subject by Francesco Franzoni, Full professor of Finance at USI and Senior Chair of the Swiss Finance Institute. The study is forthcoming in Management Science.
The analysis conducted by Prof. Franzoni, together with colleagues Itzhak Ben-David of Ohio State University and Rabih Moussawi and John Sedunov of Villanova University, focuses on the ten largest institutional investors in the United States that control more than a quarter of the entire U.S. stock market. According to the researchers, the trading strategies of the funds managed by these companies, which are dictated by centralized functions, can lead to massive one-way buying or selling of securities, thus creating "noise" in the stock prices, causing volatility in the markets and, ultimately, contributing to an incorrect valuation of the companies. Smaller investment funds, on the other hand, operate with diversified strategies and often trade against each other, cancelling out therefore the price distortions.
Another important result of the study concerns the fact that, in times of market turmoil, the securities held by these large institutional investors are subject to greater instability. As Prof. Franzoni explains, "during periods of strong market downturns, returns on securities held in large quantities by these institutional investors are significantly lower, due to massive sales which, in fact, depress share prices".
According to the authors, this issue raises new questions about the need for regulatory oversight of large fund management companies, in particular the question is whether these companies should be classified alongside large banks as systemically important financial institutions.
The Financial Times report is available online at www.ft.com/content/00bb26e7-16ac-45b1-b56e-74f8f0aa7e42
The study entitled "The Granular Nature of Large Institutional Investors" is available at